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“The hardest part is figuring out all the transactions that must take place in order
to pull off the larger deal” and determining “technically what they are,” Arthur Rosen,
a tax attorney and partner at McDermott Will & Emery LLP, said.

Deals among companies from different sectors or combinations involving spinoffs of
business units present particularly thorny taxation puzzles. And they are the types
of deals worked on by Rosen and a lineup of speakers at an Aug. 5 and 6 conference
on advanced state and local tax issues at Georgetown University Law Center.

In this report, Bloomberg BNA highlights practice tips offered by tax attorneys and
advisers at the conference that touch on income and franchise taxes, sales and use
taxes and post-transaction operations.

Income Taxes

To begin, the biggest issue to be addressed by the tax attorneys in a complicated
transaction may be income taxes on gain and the treatment by various states, Rosen
said.

Basis computation can be made particularly complicated because often a disconnect
exists between federal basis and the basis for state purposes, he said. For example,
states can have different depreciation rates. The federal super-accelerated depreciation
may not make sense from the state's perspective, Rosen said.

Complicating Income Tax

The challenging job of determining corporate income taxes after a merger, acquisition
or other major restructuring involves:

computing gain, which is made difficult by the differences in basis among federal
and state governments;

factoring various depreciation rates;

applying a tax-benefit rule;

distinguishing non-business assets from business assets; and

recognizing apportioned income from allocated income.

A company may receive a tax benefit from the federal government, reducing the basis,
but some states won't look at that reduction, causing the business to pay taxes on
a higher gain, Rosen said.

The company may challenge what it perceives as taxes on gain that is higher than its
federal taxable income.

“And cases go both ways, but in most of the cases taxpayers have prevailed, not under
the technical tax-benefit rule, which is a very narrow, technical rule, but on the
general concept it just makes no sense, it just is not fair to pay taxes on income
you never really earned or gain you never really realized,”
Rosen said.

After determining gain, distinguishing business income from non-business income may
be the second most significant to address in a major corporate restructuring, Rosen
said.

“Is the gain business income that can be apportioned every place the seller is subject
to tax or is the gain all going to one specific state?” he said.

“Generally, I’d say 90 percent of the time, taxpayers want non-business income because
the state that it will be allocated to is a very favorable state for this purpose,”
he said.

Getting There

With non-business treatment, which companies generally seek, there are two ways of
getting there, according to Rosen.

The First—The more straightforward way. The state or state court may look at the extraordinary
transaction or sale and say it's not in the “ordinary course of business,” classifying
it as “non-business income.”

The Second—A two-step analysis. The state may apply the functional test and determine that it
is “apportionable income because you sold assets that you used in the business,” Rosen
said. But don't stop there. A number of courts have said that it can be treated as
non-business income even if you use the asset in a prior, ongoing business. “If you
are getting out of that line of businesses, then that will be treated as non-business
income,” Rosen said. This is known as a cessation-of-business exception.

Potential Deals:
Get in the Loop

“Become friends—if you are junior—with someone your own age, let’s say, who is in
the strategic planning department or CFO or whatever department normally does transactions
or acquisitions or dispositions, and go to lunch with that person every two or three
weeks, and the tax partner should pay for that,” Rosen said, “because that is how
you really find out what’s going on as opposed to being told last-minute through formal
channels.”

Sales and Use Taxes

Meanwhile, liability for sales and use taxes is often festering beneath restructurings
and acquisitions, but only recently have companies started reaching out to advisersfor
early counseling.

“Over the last 10 years, now all of a sudden, the call to the sales and use tax folks
is happening a lot earlier than it used to happen,” said Elil Arasu with Deloitte
Tax LLP.

Being Diligent

William Backstrom Jr., a partner with Jones Walker LLP, explained that early and ongoing
intervention throughout a transaction facilitates critical due diligence.

“It's always better to be at the corporate dining table rather than on the menu,”
he said. “And the way you do that is you add value to these transactions.”

Adding value can include:

developing an understanding of the businesses and form of transaction;

analyzing state-specific laws;

evaluating nexus footprints;

identifying potential sales and use tax obligations;

minimizing liability through applicable exemptions and exclusions;

looking into other issues such as tax incentives, regulatory licenses and permits,
bonds and unclaimed property; and

reviewing and assisting with transactional documents.

Practice Pointer: ‘Form Over Substance'

Arasu and Backstrom both reiterated that “form over substance” is the general governing
rule when assessing sales and use tax implications. Some “substance over form” concepts—seen
in the income tax world—have started to seep into the sales tax world, such as the
step transaction doctrine, but they aren't the norm.

Federal Doesn't Govern

At the outset, practitioners cannot presume that the sales and use tax consequences
of corporate restructurings and acquisitions align with the federal tax treatment.
Nor can they assume that avoidance of federal and state income taxes will protect
against sales and use tax liability.

“We have to think that just because it's tax-free for federal purposes doesn't mean
it's going to be tax-free for state income tax purposes, and more importantly, it
doesn't mean that it doesn't have tax implications for sales and use taxes, employment
taxes, licenses, unclaimed property and other things like that,” Backstrom said.

Which means that any transfer of tangible personal property (TPP), and perhaps other
dispositions of taxable property, in exchange for consideration may trigger sales
and use tax obligations. However, Backstrom cautioned that liability may not be restricted
to transactions involving TPP, as some states have expanded the definition of TPP
or expanded the scope of the sales and use tax.

Mining to Mitigate Liability

If a transaction is potentially taxable, Backstrom said that practitioners have a
duty to mine for state-specific exemptions and exclusions—including those tailored
to types of individuals, property or transactions.

Of the many examples, some potential exemptions and exclusions include:

the isolated, occasional or casual sale exemption,

the sale for resale exemption, and

the manufacturing machinery and equipment exemption.

Immediate Compliance

And just as income tax principles generally don't control sales and use tax considerations,
compliance also varies. Whereas an income tax return may not be due for months after
a transaction closes, the purchase of assets or entities can trigger sales and use
tax compliance immediately—potentially requiring a return within days or weeks, Backstrom
explained.

Post-Transaction

Finally, mergers and acquisitions provide lots of opportunities to change things in
post-transaction operations, but involve a host of income and sales tax issues that
may require focusing on material states and taking reasonable positions where there
is little or no guidance.

Treatment of Stock Sales

When it comes to entity acquisitions, sellers like to sell stock and buyers like to
buy assets. The parties can elect to have a stock sale deemed to be an asset sale
at the federal level for income tax purposes under Internal Revenue Code Section 338(h)(10). However, a stock sale deemed to be an asset sale at the federal level may not be
respected at the state level.

A bulk sale of a business can also give rise to sales tax liability that varies state
by state

Filing Returns

Compliance issues also arise. Short period tax returns may need to be filed with short
due dates in certain single entity states. Brian Sullivan of Deloitte Tax in Atlanta
said he is seeing more instances in which sellers are telling buyers to file tax returns
for them.

Treatment of NOLs, Credits

Net operating losses (NOLs) is another area where Sullivan has seen a lot of activity
recently.

Alysse McLoughlin, a partner in the New York office of McDermott Will & Emery, said
to look state-by-state to see if NOLs can be used.

Moreover, companies with tax credits and incentives need to be careful when selling
or transferring assets.

Important Questions to Ask:

For bulk sales, is there an “occasional sales” exemption from sales tax?
(Some states like New York have no exemption.)

For sellers having buyers file returns, who is going to be audited and who's responsible
for late filing penalties?

For combined entities, are NOLs going to be allocated (like they are in California)?

Also for combined entities, does the state have good rules on allocation (like New
York)
or is there little or no guidance?

Do credits stay with the seller or transfer with the assets?

Will there be recapture of tax credits upon sale?

Will the acquiring company need to reapply for tax credits as a result of the transfer?

Focusing on What’s Important

With so many issues and often limited guidance, tax planning and compliance can be
a challenge. Materiality is big in state mergers and acquisition, Sullivan said.

Trying to figure out the rules in all states may require focusing on the materiality
states and taking reasonable positions in states where there's no guidance, McLoughlin
said.

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